|Business Cycle & Stock Performance|
Because sector funds have a narrow focus, you should be familiar with the factors that may affect the industry in question.
Based on a comprehensive analysis of the relevant facts, you may arrive at a judgment as to what the industry's performance will be like going forward. One technique commonly used by is to monitor the business cycle for clues as to what may be happening in the market.
Business Cycle Basics
By examining empirical evidence, the investor can attempt to create a framework for viewing present and future events as they unfold. There are two key questions the investor may want to ask:
1. Will the historic pattern hold, or will it be altered? To answer that, you'll need to ascertain whether the factors driving today's market are fundamentally unchanged, or whether the situation has evolved incrementally or even been radically changed.
2. Has the market already taken the anticipated future events into account? If the factors driving the industry are the traditional cyclical ones, the market usually will have taken them into account, because they are expected. If the factors represent a new element in the equation, then the market may not be expecting them and may not have adjusted accordingly.
Business Cycle and Relative Stock Performance
The following chart shows a typical business cycle and the points at which various economic sectors tend to outperform the broader market. Click any number in the chart to learn about the cyclical characteristics of a particular industry.
The chart above shows a typical business cycle and the points at which various economic sectors tend to outperform the broader market. Please note that the chart should be used for illustrative purposes only. The chart is a historical representation of stock performance movements relative to the business cycle and is not intended to convey any current or future economic outlook. Choose a Sector for a detail description of its role in the business cycle.
Source: 2000, Standard and Poor's, a division of McGraw-Hill Companies, based on a study analyzing the differences in market returns of 90 Industries vs the S&P 500 during 10 complete economic cycles from December 1945 - December 1995.
Stocks in consumer non-cyclicals (food) and consumer growth industries (cosmetics, tobacco, beverages) tend to experience fairly steady demand and are less sensitive to changes in the business cycle. These stocks typically attract investors when the economic cycle or bull market has matured, or is in the early stages of contraction.
I will use the BP Indices and some of the older Amex Industry Holder ETF's to show these relationships. RtS
Consumer Cyclicals (durable & non-durable)
Stocks in this category include durables and non-durables that are sensitive to interest rates as well as the business cycle. Investors typically seek them out when the economy is in the late stages of contraction.
In general, stocks in this sector move similarly to consumer non-cyclicals. This sector is considered defensive, meaning companies in this sector are generally unaffected by economic fluctuations. The healthcare industry consists of pharmaceutical firms, HMOs, biotechnology firms and medical equipment suppliers. Pharmaceutical companies are affected by competitive market shares, the pace of FDA approvals, patent lives, and the strength of the R&D pipelines. Many biotechnology firms are still in the development stage with their fortunes largely determined by investor perceptions of the relative merits of their R&D pipelines. With future new financing likely to be more difficult to obtain than in the past, strategic alliances between major drug companies and biotech firms are expected to increase.
Stocks in housing-related industries tend to respond well to falling interest rates and are often targeted by investors in the mid to late stages of an economic contraction. Non-mortgage-dependent banks are generally driven by commercial and consumer loan growth, and tend to be favored by investors during the middle of the cycle.
Technology stocks can be cyclical to the degree that they depend on capital spending and business or consumer demand. However, they may also have long-term growth potential as technological products find broader applications and as new technologies are developed. Technology stocks are usually popular during early to mid stages of an economic expansion.
Profits of basic industries are driven by high utilization of capacity and strong market demand for products. Therefore, their stocks tend to be popular with investors late in an economic expansion. For basic material companies, the global economic picture and supply/demand equation also affect stock price movements.
Capital spending tends to increase midway through the business cycle, as the economy is heating up and higher demand for products leads companies to expand their production capacity. Demand in global export markets is key for agricultural equipment, industrial machinery, and machine tools.
Railroads and other surface carriers tend to react early to a pickup in the economy. Airlines are subject to cyclical fuel costs, usage versus capacity, and competitive pressures on airfares.
This category includes large integrated international companies, domestic exploration companies, and energy services companies. Each industry has its own dynamics, but ultimately all are driven by the supply and demand picture for energy worldwide. Political events have historically had a major impact on these industries. Stocks tend to be popular with investors late in the business cycle.
Electric companies have historically been very sensitive to interest rates because of the large debt financing costs they must incur in order to build their infrastructures. These stocks tend to perform well in an environment of declining interest rates. Telephone companies may offer attractive long-term growth opportunities, as they diversify and compete in recently deregulated telecommunications markets.
Precious metals and the stocks of companies that mine and process them can be affected by industrial and consumer demand, but the largest factor contributing to volatility in this category is generally inflationary pressure. Investors often flock to this category late in the expansion cycle.